Identifying a textile stock: Do's and don'ts

The debt-laden Indian textile industry that was embroiled in BIFR cases until the early part of this decade, spun a turnaround with the lowering of interest rates and dismantling of the quota regime. Aided by lower interest rates, restructuring packages from financial institutions and the more recent Technology Upgradation Fund (TUF), the sector today is well poised to capture growth opportunities.

Apparels vs. Home textiles

The product profile of domestic textile players needs to be understood in relative terms with that of players in the lead competing nations. What differentiates Indian textile industry from its low cost peers (namely China, Pakistan and Bangladesh) in the highly competitive post quota era is the relatively de-risked business models. While players in the apparel business have upgraded their product mix to meet customised demand of apparel exporters and developed made ups from fabrics, the home textile players enjoy a distinct advantage against their peers in the neighbouring countries in terms of being 'first-movers'.

While competition is relatively lower in the domestic apparel fabric market (due to high degree of sophistication required in designing and finishing), the market for export of home textile is very favourable for Indian players, with most of the European companies having gone into bankruptcy. Also, while the apparel segment enjoys higher margins (as compared to home textiles), the home textile division is a hedge against changing fashion trends in the apparel segment. The two business models thus, offer diversification in terms of products, customers, fashion cycles and currency risks.

Cyclicality parallel to discretionary income

The cyclicality in the textile business is closely linked to the discretionary income in the hands of people, in other words - the buoyancy in the economy. However, here one needs to note that with the global markets now being accessible, the industry slowdown related risks in the domestic economy remains limited. We therefore enlist some of the key demand and supply drivers taking into consideration the dynamics of the global textile markets.

Demand drivers: The global textile industry is valued at US$ 440 bn. US and European markets dominate the global textile trade accounting for 64% of apparel and 39% of textile fabrics market. With the dismantling of quotas, global textile trade is expected to grow (as per Mc Kinsey estimates) to US$ 650 bn by 2010 (5 year CAGR of 10%). Although China is likely to become the 'supplier of choice', other low cost producers like India would also benefit as the overseas importers would try to mitigate their risk of sourcing from only one country. India's textile export (at US$ 15 bn in 2005) is expected to grow to US$ 40 bn, capturing a market share of close to 8% by 2010. India, in particular, is likely to benefit from the rising demand in the home textiles and readymade apparels segment, wherein it has competitive edge against its neighbours. Nonetheless, a rapid slowdown in the denim cycle poses risks to fabric players.

Supply drivers: India is the third largest producer of cotton in the world after China and US and has the largest area under cultivation. Cotton, a key raw material in the textile and garment industry, accounts for about 30% of the fabric cost and 13% of the garment cost. India has an abundant supply of locally grown long staple cotton, which lends it a cost advantage in the home textile and apparels segments. India also enjoys a significant lead in terms of labour cost per hour (US$ 0.6 in 2004), over developed countries like US (US$ 15.1) and newly industrialised economies like Hong Kong (US$ 5.1), Taiwan (US$ 7.1), South Korea (US$ 5.7) and China (US$ 0.9). Also, India is rich in traditional workers adept at value-adding tasks, which could give Indian companies significant margin advantage.

Textile stocks- Key considerations

Demand slowdown: Although the domestic demand for textile remains robust, the same is not true for the branded garment segment. Therefore, manufacturers largely rely on the overseas markets for vending their products. Of this, the US and the EU consume nearly 90% of exports. For home textile companies, the domestic market being dominated by unorganised players, nearly 90% of the produce is exported. However, with the US and the EU economies now showing signs of slowdown, the same will inevitably have an impact on the incremental demand. Key ratio - Exports / Total turnover

Exchange rate risks: Given the volatility of the rupee against foreign currencies (especially against the US dollar), the exposure to the overseas markets renders the textile companies to significant foreign exchange risks. Although most textile companies have some hedging mechanisms (example, forward bookings) in place, an unexpected movement in the rupee can obliterate such efforts. Key ratio - Forex loss / Operating expenses

Hardening interest rates: Rise is interest rates at a time when most textile companies are heavily leveraged due to the ensuing or ongoing capex plans is bound to pressurise their interest coverage ratios. In fact, this is the time that will test whether the companies have taken cognizance of the lessons learnt during the previous interest rate cycle. Nevertheless, companies that have already taken advantage of the TUF (Technology Upgradation Fund, offering loans at 6% subsidy - proposed to expire in March 2012) to fund their capex are, however, better off than their peers. Key ratios - Debt /Equity, Interest coverage

Overcapacity: Companies in the apparel and home textile segments alike have huge capacities coming up in the near term. However, the underutilisation of these capacities, led by flagging demand, may deny any operating leverage, thus forcing them to compromise on their operating margins. Key ratio - Capacity utilisation

Logistic disadvantage: India's logistic disadvantage due to its geographical location can give it a major thumbs-down in global trade. The country is distant from major markets as compared to its global competitors like Mexico, Turkey and China, which are located in relatively close vicinity to major global markets of US, Europe and Japan. As a result, high cost of shipments and longer lead-time coupled with lack of infrastructure facility may prove to be major hindrances. Companies that have achieved integration between the various links in the supply chain through their global subsidiaries stand to gain in this regard.

Competition against global leaders: With foreign brands being allowed to make a foray into to India through the FDI route (FDI in single brand retailing) it calls for competitiveness on the part of the Indian players. Be it through the joint venture route or otherwise, companies that have so far been taking the advantage of in-licensing the established brands now need to focus on building their own.

How to value a textile stock?

Earnings of the textile sector have been very volatile in the past due to reasons like change in raw material prices (wool and cotton), slower demand growth, foreign exchange sensitivity and competition. The scenario is likely to remain the same in the future as well, despite growth opportunities in international markets. Since textile is a mature industry, companies in the sector are valued on the basis of their price to forward earnings multiple (P/E). Having said that, investors should also accord some premium in valuing companies that have differentiated themselves on the following parameters.

Value addition: Focus on higher value addition and thrust on enriching product mix is India's attempt to differentiate itself from regional peers such as China and Pakistan. India's higher price realisations have reasonably compensated for the relatively lower market share of exports to the US as compared to China. Further, once the higher capacities get commissioned, we believe that the Indian companies (into value added products) would be in a position to garner better margins and healthier profitability in the future.

Yet to reap the fruits of capex: Most companies in the sector timed their expansion plans FY04 onwards, so as to avail themselves of the funding under TUF (earlier due expiry in March 2007). This led to the capex-spending phase in the textile sector peaking in the last two fiscals. Against this backdrop, we believe that a majority of the capex in the sector has already been incurred or is in the last leg of completion, the benefits of which should start filtering in from FY08 onwards, once the new capacities stabilise and the utilisation levels get normalised. Nonetheless, with the TUF duration getting elongated and proposed investments set to be completed by FY10, the capex benefits are yet to become visible.

Overseas alliances to help move up the chain: Several Indian textile companies have formed alliances with their global counterparts, particularly those with strong front-end capabilities, in a bid to access global markets, tap technological know-how, design skills and branding and retailing ability. The alliances have been struck in most cases by way of JVs or stake acquisition.

Retail footprint: Most large textile companies in India, realising the growth potential in domestic retailing, have drawn up aggressive strategies to expand their footprint in the domestic market. These include companies like Welspun and Himatsingka, which were traditionally export-oriented, as also Raymond, which has been the pioneer in domestic textile retailing. Home textile (furnishing) companies like Himatsingka and Welspun have also taken steps in this direction with their outlets 'Atmosphere' and 'Spaces' respectively.

While strong business prospects, valuations and peer comparison do serve the purpose of identifying a textile stock, the investment argument must be backed by a strong track record of the management, its vision and its integrity. The same especially holds true in case of the textile sector where the management is responsible for the survival of the company in times of downturn and enhancement of the shareholders' return in good times.

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